Taxes

Asset Allocation Versus Tax Allocation

By Chris Duderstadt

May 22, 2023

Asset Allocation Versus Tax Allocation

Key Points – Asset Allocation Versus Tax Allocation

  • Defining Asset Allocation and Tax Allocation
  • Reviewing Ways to Reduce Your Taxes in Retirement
  • How to Go About Controlling Your Taxes
  • 9 Minutes to Read | 23 Minutes to Watch

Do You Understand Asset Allocation Versus Tax Allocation?

Dean Barber and Bud Kasper have talked about asset allocation and tax allocation several times on America’s Wealth Management Show. And they’ve discussed asset location quite a bit too. Do you have a good understanding of all three? Whether you do or not, they’re going to offer some keen insight on asset allocation versus tax allocation and why both of them are important, so make sure to pay close attention.

Asset Allocation and Tax Allocation Are Oftentimes Intertwined

If you haven’t noticed Dean and Bud love to talk about tax planning. Well, your tax allocation plays a key role in how flexible you can get with tax reduction strategies in retirement. While tax allocation isn’t as commonly discussed as asset allocation, it’s just as critical, if not more critical when it comes to retirement planning. Asset allocation and tax allocation can be intertwined when developing a financial plan, which can make the asset allocation versus tax allocation discussion even more confusing.

Before Dean and Bud really dive deep into explaining the differences of asset allocation versus tax allocation, they want to think back to the beginning of their careers for a minute. Tax planning wasn’t something that they ever envisioned talking about with clients and prospective clients when they were breaking into the industry. However, the two biggest expenses for most people in retirement are taxes and health care. Dean and Bud are going to help us with covering taxes today in this discussion of asset allocation versus tax allocation.

Dean and Bud’s Top Three Ways to Reduce Taxes in Retirement

Bud and Dean are going to elaborate on why they think tax allocation is just as important, if not more important, than asset allocation. To set the stage for doing that, they’re going to share their top three ways to reduce taxes in retirement. We’ll start with Bud and then go straight to Dean.

Bud’s Top Three Ways to Reduce Taxes in Retirement

  1. Tax bracket management. Oftentimes, we do tax bracket management by doing Roth conversions.
  2. Introducing tax-free investments to the portfolio. When is it smart to do that?
  3. Knowing what bucket to take your money from. What’s the most efficient way to get the net result to the level that’s acceptable to our clients?

Dean’s Top Three Ways to Reduce Taxes in Retirement

  1. Bracket maximization. This is the same thing that Bud was alluding to with tax bracket management, so they matched there. We’ll still give another quick example. Let’s say you’re in the 22% bracket, but you know when Required Minimum Distributions hit that you’re going to be in the 24% bracket, go ahead and go to the top of the 22% bracket and convert from a traditional IRA to a Roth IRA because you know that you’re eventually going to need to pay 24% on that.
  2. Roth 401(k) and Roth IRA. Dean couldn’t believe that he didn’t match with Bud on this one as well. It’s important to get money in the Roth as soon as possible. And don’t be afraid to do Roth conversions after retirement. In fact, some of the most opportune times to do Roth conversions occur after retirement because you can control your income.
  3. Understanding the provisional income rules. Those are the rules that surround how much, if any, of your Social Security is taxable. If you don’t understand those rules, you might end up paying more taxes than you need to.

Understanding Tax Allocation

With tax allocation, there are really two components. There’s asset location, which we mentioned earlier. That’s looking at the tax buckets that Bud mentioned. Let’s say you have two accounts—a taxable account and tax-deferred account. So, you have a traditional IRA and a none-IRA, whether it’s owned by a trust, jointly with a spouse, or you individually. Whatever that account makes in the taxable bucket is taxable every year. You’ll get your 1099-DIV or 1099-INT and report that on your tax return.

Let’s say that you wanted to have a 50-50 portfolio of stocks and bonds. Which account should own your bonds? The tax-deferred account or the taxable account? And which account should own the stocks?

“What we see far too often is that people will ignore the asset location. They’ll just want that they want 50-50 and split their taxable and tax-deferred accounts 50-50. The reality is that we want anything that is kicking off taxable interest to be in the tax-deferred account. So, you want all your bonds in your tax-deferred account and your stocks in your taxable account. Why? Because stocks, unless you sell them, don’t cause taxation. If they have a dividend, it’s a qualified dividend. That means it gets favorable tax treatment that can be from 0-20%. If you’re above a certain level, it can be 23.8% because you need to put the ACA surtax on top of that. If you do that, the money is doing the same thing. You have the same asset allocation. You’ve just located the assets in different buckets.” – Dean Barber

Reviewing Roth vs. Traditional

Remember that tax-deferred simply means that you’re postponing the tax. It will come in the future. That’s the traditional IRA or 401(k) or even a non-qualified annuity. The traditional 401(k) is a large portion of most people’s assets. If you know Bud, though, he’s not most people in that instance. He even considers himself to be a Rothaholic.

“Get rid of Uncle Sam. Don’t let him in your life. I’m starting to sound more like Ed Slott, aren’t I?” – Bud Kasper

At some point, you’re going to need to take distributions out of your IRA. How are you going to mitigate taxes? What bracket are you going to be in that year if you’re considering a Roth conversion? You need to understand how much and when.

If you really want to get a good understand of Roth vs. traditional and start seeing how forward-looking tax planning can make a massive difference for you as you’re planning to get to and through retirement, download our Tax Reduction Strategies guide. It was put together by our CFP® Professionals and in-house CPAs. Download your copy below to figure out how to pay as little tax as possible over your lifetime, not just in one year.

Asset Allocation Versus Tax Allocation

Download:Tax Reduction Strategies

The Tax Reduction Strategies guide isn’t an implementation guide. It’s not a step-by-step guide. It consists of tax planning strategies. You need to have an individualized tax plan that’s a part of a comprehensive financial plan that’s put together by a good CFP® Professional and a CPA who is looking over it from a tax perspective. The CPA will outline how to get your income to your checking account each month in the least taxing way possible.

The Winner and Loser of Tax Planning

When you talk about tax reduction strategies, you need to understand that there’s a winner and loser with tax planning. The winner is either you or Uncle Sam. How are you going to win the game of tax planning? It’s important to realize that you have more control over your taxes in retirement. That’s a big component of winning the tax planning game.

Creating Tax Diversification

Tax diversification is key in this discussion about asset allocation versus tax allocation. Tax diversification simply means that you should have some money in traditional, some money in Roth, and some money in accounts that are taxable. That gives you flexibility.

“In most cases, you don’t find yourself spending all your taxable money first, then all your tax-deferred money, and then have only Roth money left. The goal again is to pay as little tax as possible over your lifetime and your beneficiaries’ lifetimes. As long as that money is in play, taxes will be a part of the game. Tax planning doesn’t stop at your death.” – Dean Barber

When you’re married and filing a joint tax return, your taxes at every level of income are lower than if you are single. If one spouse passes away and the level of income is sustained, taxes are going to be much higher for the surviving spouse. The reality is that you need to factor that into your financial planning process.

Life Insurance as a Wealth Transfer Vehicle

Dean has an example to share from one of his clients who recently inherited money after their mother passed away. Her son was the sole beneficiary. The son and his spouse have been clients for quite a while, as was the mother. When the mother was younger, Dean did something to maximize her estate.

“We actually used life insurance to maximize her estate in a tax-free manner. Interest rates were fairly low when we did this. We took a little bit of money and put it into a single premium immediate annuity. We used the income that was coming off the single premium immediate annuity, which was mostly non-taxable because it was return of principal, to fund a $1 million life insurance policy. That way, when the mother passed, $1 million came tax-free to the son.” – Dean Barber

The question then became what to do with that $1 million. The son and his spouse had an opportunity. They had money from the insurance company. They needed to figure out if they could use some of that money to take out Uncle Sam. Dean and the couple decided it was best for them to use part of the $1 million and use it to convert a large amount of the son’s IRA to a Roth IRA to get tax-free income.

Putting Your Interests Ahead of Our Own

Dean and Bud want to emphasize that the CFP® Professionals at Modern Wealth are fiduciaries. That means that we’re bound to putting your interests ahead of our own. If Dean used the couple’s $1 million to pay the taxes to convert a $2.5 million IRA to Roth, that’s now $1 million that Dean can’t manage. He can’t charge a fee on it.

“When you get a CPA in the same room as the CFP® Professional, they’re going to say that the best use of money in that situation is to pay the tax on the IRA now and get it over into a Roth. Eventually, you’re going to lose a big portion of the money that’s in the traditional IRA. You need to plan that out.” – Dean Barber

Considering Municipal Bonds

Using life insurance in that fashion made Bud think about municipal bonds. Why’s that? Well, as most people prepare for retirement, they also won’t think about using municipal bonds as an investment strategy. If you have so much income and realize Uncle Sam is going to be in your pocket every year, you’re probably going to gravitate toward that type of solution. But again, most people’s money is in their tax-deferred account.

If most of your money is in your tax-deferred account, traditional bonds will be the better options. That’s why a lot of people won’t think about municipal bonds. We want you to understand that if you have a lot of taxable money, there are ways to achieve the asset allocation that you want in a much more tax efficient manner.

Direct Indexing

In other words, you can own municipal bonds as opposed to traditional bonds and do your equity investing in your taxable account through direct indexing. With direct indexing, you’ll have a group of individual stocks mirror an index.

“The advantage of that is that direct indexing is looking for tax-loss harvesting opportunities on a daily basis. You’re trying to minimize the tax liability. For example, let’s say that someone had done a direct indexing account that had mirrored the S&P 500 and started right before COVID in January 2020. The value of your account is going to be the same as if you took it and bought a Vanguard S&P 500 ETF. However, that individual would have a net capital loss. Let’s say you started with $1 million and now have about $1.2 million. From a tax perspective, you would have a net capital loss in your portfolio of about $200,000. That means that account could grow another $200,000 before there’s any on that account.” – Dean Barber

Dean’s point is that that person would have a $1.2 million account with a $200,000 capital loss embedded. So, they could pull that entire $1.2 million out and not pay any taxes. If they bought the S&P 500 ETF, it would be worth $1.2 million. But if they tried to get the $1.2 million, the $200,000 growth is now taxable.

Controlling Your Taxes

It’s so critical that people understand that their taxes leading up to retirement, and even more so in retirement. Hopefully, this discussion on asset allocation versus tax allocation has helped illustrate that for you.

“If you want to know how wealthy people are staying wealthy, it’s because they’re controlling their taxes. They’re taking advantage of losses when they occur to mitigate future capital gains that they would have.” – Bud Kasper

The bottom line is that tax diversification is critical. You need money in taxable, tax-deferred, and tax-free accounts. If you’re wondering why you would still want to leave some money in a tax-deferred account, there is a good reason to. Once you turn 70½, you can do all your charitable contributions out of the traditional side of your IRA or 401(k)—effectively getting your money out tax-free through Qualified Charitable Distributions. This is a popular option for those who are charitably inclined.

Do You Have Questions About Asset Allocation Versus Tax Allocation?

Like we said from the get go, understanding asset allocation versus tax allocation can be confusing, but both are very important. The picture can be a whole lot clearer when you see how they personally impact you. We have a few different ways to show you that.

One way is through using our industry-leading financial planning tool. It allows you to build a financial plan that gives you confidence that you’re doing the right things with your money, freedom from financial stress, and time to spend doing the things you love. You can begin building your plan at no cost or obligation and from the comfort of your own home by clicking the “Start Planning” button below.

Asset Allocation Versus Tax Allocation

START PLANNING

We also want you to get a better feel of what it’s like to work with a CFP® Professional that’s working alongside a CPA. If you have questions about asset allocation versus tax allocation or about the financial planning process as a whole, you can schedule a 20-minute “ask anything” session with one of our CFP® Professionals. We can meet with you in person, by phone, or virtually depending on what works best for you.

Asset Allocation Versus Tax Allocation | Watch Guide

00:00 – Introduction
01:20 – Dean & Bud’s Top 3 Ways to Reduce Taxes in Retirement
04:07 – Components of Tax Allocation
07:44 – Tax Reduction Strategies
10:13 – Tax Bracket Management & Tax Diversification
11:45 – Taxes After the Death of a Spouse
12:51 – Paying Uncle Sam with Insurance Money
16:40 – Tax Efficient Investing
21:17 – What We Learned in Today’s Show

Resources Mentioned in This Episode

Other America’s Wealth Management Show Episodes

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Investment advisory services offered through Modern Wealth Management, LLC, an SEC Registered Investment Adviser.

The views expressed represent the opinion of Modern Wealth Management, LLC, an SEC Registered Investment Adviser. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management, LLC does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.